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Ten considerations in a quality of earnings study
Mar 25, 2022 · Authored by William A. Chapman
Preparing for a potential acquisition
When entering into a preliminary agreement to purchase a going concern, it is considered prudent for the buyer to contract independent professionals to conduct a quality of earnings study in order to validate the buyer’s investment thesis. A proper quality of earnings analysis encompasses a variety of elements. The following is a short list of considerations when determining the appropriate scope of a quality of earnings study.
1. A quality of earnings study is not an audit
Clients frequently ask why there is a need to perform a quality of earnings study when the subject company is already audited. There are several differences between an audit and a quality of earnings study. Such differences include the following: In a quality of earnings, the focus is on the economic earnings vs. the balance sheet serving as the focus in an audit; a quality of earnings is a consulting engagement, not an attest service, providing flexibility in the approach and scope; and the materiality is much lower in a quality of earnings study than an audit.
2. What gives earnings "quality?"
In order for an earnings measure to be considered of high quality, it must reflect free cash flow and it must be sustainable. Earnings that are “tied up” in accounts receivable, for example, do not have much value because, despite being recognized, they have not yet been realized. In the same vein, earnings that are not sustainable because of understated expenses due to an unfilled executive position, as an example, would overstate sustainable earnings.
3. EBITDA vs. other earnings metrics
Many buyers default to earnings before interest, taxes, depreciation and amortization (EBITDA) as a proxy for free cash flows. Certainly, EBITDA is easy to calculate and easy to understand. However, unless the target company does not pay any taxes, has no working capital needs and does not require any investment in long-term assets, EBITDA may not be the best tool available. While each situation is different, the buyers should consider if what they really want to know is what cash flows will be available to the stakeholders (e.g., equity and funded debt holders). In that case perhaps a free cash flow model would be more appropriate. There are different mathematically equivalent methods of calculating free cash flows (FCF), but this is a common one: FCF= EBITDA ± ∆NWC – C – t
Where:
EBITDA is reported EBITDA, net of all due diligence adjustments
NWC is reported net working capital, exclusive of cash and funded debt, net of all due diligence adjustments
C is normal replacement capital expenditures, net of the proceeds from the sale of fixed assets
t is the cash taxes paid
4. Isolating the earnings
While a due diligence study should never be confused with an audit, due diligence does have the following procedures in common with an audit that help to isolate earnings. When attempting to isolate the earnings of the trailing 12 months, the due diligence professional should be performing a proof of cash. (If the cash cannot be proved, then the buyer cannot be sure of anything.) Next, revenue recognition should be tested to ensure it is in compliance with the company’s policy, as well as with general accepted accounting principles. Any variations from either could have a material effect on earnings calculations. Finally, the beginning and ending balance sheets of the trailing 12 months should be scrutinized to determine if revenues and expenses are in the proper periods, liabilities and reserves are appropriately recorded, etc.
5. Effect of net working capital
Occasionally, we are asked to focus only on EBITDA and disregard the net working capital. However, buyers should keep in mind the adjustments on net working capital may affect earnings. As an example, if bonuses have not been accrued but only recorded when paid, the difference between the proper recording of the accrual on the beginning and ending balances sheets may impact earnings unless the bonus amounts paid in each period are identical.
Evaluating the accuracy of the net working capital accounts should not be overlooked.
6. Seller’s adjustments
The seller’s adjustments to EBITDA usually include the obvious non-recurring expenses and perhaps excess compensation. The study for a buyer should include validation of these claims including obtaining original documentation. Estimates should not be accepted and the rationale for each adjustment should be challenged.
7. Due diligence adjustments
These adjustments are those identified by the due diligence team and might include overlooked onetime expenses, accounting errors, effects of unrecorded or under recorded liabilities or even a reversal of the seller’s adjustments that fail to hold up to scrutiny. The number of these adjustments should give the buyer not only a better understanding of the economic earnings, but provide some insights into the quality of the company’s information and the strength of the finance team.
8. Pro forma adjustments
Pro forma adjustments are frequently overlooked and misunderstood by sellers. These adjustments usually are utilized to “normalize” the trailing 12 months’ earnings. Such adjustments might be made to annualize a midterm rent increase or account for a new union contract. The pro forma adjustments address the sustainability of the business for the buyer.
9. Concentrations and operational risks
While buyers should consider the quality of the earnings, they should not lose sight of the relative risk of those earnings. Many studies will cover such issues as customer concentrations, but the buyer may want to consider other concentrations as well (i.e., industry, product/service, distribution channel, etc.). The buyers should evaluate these concentrations on a gross profit or contribution margin level. In addition, other risks that buyers may wish to consider include cost structure, commodity dependence, price strategy and elasticity, key man issues and dependency on intellectual property.
10. Other considerations
Other diligence procedures that might provide insight on the quality of earnings that you should discuss with your due diligence advisor include the following:
- Run rate study – if the company is in a high growth mode or in sharp decline, the run rate may be more relevant than the most recent trailing 12 months. This is also true with assessing the net working capital to be delivered at closing (the “PEG”).
- Related party analysis – if the company has numerous related party transactions, the buyer may want to be satisfied that the transactions are at arm’s length or that any change in control will not affect critical relationships with customers or suppliers.
- Debt and debt-like items – liabilities that do not provide any value to the company, but may have an effect on future cash flows, may need to be dealt with in negotiations. Such liabilities might include pending regulatory or legal disputes, underfunded pension plans and deferred compensation plans.
- Commercial analysis – if the investment thesis is highly dependent upon management’s projections, it may be necessary to analyze the competitive environment, the go-to-market strategy and the existing customers’ perception of the company and its products.
This list represents an overview of some of the areas of focus a buyer should consider when attempting to validate their investment thesis. To be sure, the buyer should center its efforts on specific areas of concern, but it is critical for the buyer to understand the interrelationships of the financial, tax, operational, and legal aspects of company order to help keep the due diligence efficient, focused and relevant.
For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.
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